Arbitrage and the Regulation of Exchange-traded Funds Under the Investment Company Act

40 Pages·2010·0.26 MB·English

by  Daniel J. Grimm

A PROCESS OF NATURAL CORRECTION:
ARBITRAGE AND THE REGULATION OF
EXCHANGE-TRADED FUNDS UNDER THE
INVESTMENT COMPANY ACT
Daniel J. Grimm*
I. INTRODUCTION
In early 2008, the Securities and Exchange Commission (SEC) issued
for the first time exemptive orders permitting fully transparent actively
managed exchange-traded funds (ETFs) to list on national stock
exchanges,1 with the first listing occurring on March 25, 2008.2 Also in
March, the Commission issued proposed rule 6c-11 under the Investment
Company Act of 1940 (the “1940 Act” or the “Act”),3 which would exempt

* J.D. 2007, Columbia University School of Law. The author is an Associate in the
Washington, D.C. office of Sullivan & Cromwell LLP. This Article reflects the views and
opinions of the author, which should not be imputed to any other person or entity. This
Article does not contain advice of any kind.
1. See, e.g., WisdomTree Trust et al., Order Under Sections 6(c), 12(d)(1)(J) and 17(b)
of the Investment Company Act of 1940, Investment Company Act Release No. 28,174,
2008 SEC LEXIS 1360 (Feb. 27, 2008); see also WisdomTree Trust, et al., Notice of
Application, Investment Company Act Release No. 28,147, 73 Fed. Reg. 7776 (Feb. 6,
2008) [hereinafter WisdomTree Trust, Notice of Application].
2. The first actively managed bond ETF, the Bear Stearns Current Yield Fund (YYY)
was launched on the American Stock Exchange (AMEX) on March 25, 2008. See Murray
Coleman, Bear Stearns Launches First Ever Active ETF, SEEKING ALPHA, March 25, 2008,
http://seekingalpha.com/article/69871-bear-stearns-launches-first-ever-active-etf. The fund
was liquidated in early October. See Scott Ebner, Bear Stearns Current Yield Fund (Ticker:
YYY) to be Liquidated, ETF Notice #08-040, American Stock Exchange, Sept. 29, 2008,
http://www.amex.com/amextrader/tdrInfo/data/axNotices/2008/etf08040.pdf. Other
actively managed ETFs, including equity-based funds, continue to trade. See, e.g., NYSE
Euronext, Press Release, “PowerShares Lists its First Ever Actively-Managed ETFs on
NYSE Arca,” Apr. 11, 2008, http://www.nyse.com/press/1207739565764.html.
3. Comments on the Proposed Rules were due May 19, 2008. Exchange-Traded
Funds, Investment Company Act Release No. 33-8901, 73 Fed. Reg. 53, at 14,618 (Mar. 18,
2008) (to be codified at 17 C.F.R. pts. 239, 270 and 274) [hereinafter SEC Proposed Rules].
While it is difficult to predict when the SEC is likely to implement the Proposed Rules,
some practitioners anticipate “that the likely implementation date for any final rules based
95
96 U. OF PENNSYLVANIA JOURNAL OF BUSINESS LAW [Vol. 11:1
transparent ETFs—those that track a published securities index or are
actively managed with disclosed portfolio holdings—from various
requirements of the Act.4 After years of speculation about when the SEC
would approve the first actively managed ETFs,5 the first structures
acceptable to regulators are more of the same,6 with a twist. While the
newly-approved actively managed ETFs increase flexibility by permitting
portfolio holdings to detach from published indices, they nonetheless
remain fully transparent, much like their index-tracking predecessors.7 As
the SEC notes, “an actively managed ETF would operate in the same
manner as an index-based ETF,”8 with Intraday Value transmitted every
fifteen seconds.9 Daily disclosure of portfolio holdings, a feature
emblematic of the traditional equity index structure, also characterizes the
new, actively managed ETFs approved by the SEC.10
Still, while the first actively managed ETFs do not free innovators
from transparency requirements, the SEC nonetheless indicates that its
recent actions do not foreclose the possibility that future structures may
operate with less openness. In a comment that could easily encourage a

on the Proposed Rules would occur no earlier than the beginning of 2009.” Client
Advisory, Katten Muchin Rosenman LLP, SEC Proposes New Rules to Streamline ETF
Formation (Mar. 24, 2008), http://www.kattenlaw.com (search “ETF”; then follow article
hyperlink).
4. SEC Proposed Rules, supra note 3, at 14,618; see Exchange-Traded Funds, SEC
News Dig., Issue 2008-49 (Mar. 12, 2008), http://sec.gov/news/digest/2008/dig031208.htm
(explaining further how the proposed rule changes would impact Investment Company Act
exemptions applicable to ETFs).
5. See John Authers & Rebecca Knight, Active Solution is Within Reach, FIN. TIMES
USA, Jan. 30, 2007, at 1 (“It has been talked about for years, but 2007 might be the year that
the first actively managed exchange traded fund makes it to market.”); Diya Gullapalli,
Actively Traded ETFs: A Step Closer to Reality, WALL ST. J., Feb. 5, 2008, at C3
(“Regulators appear to be on the verge of approving a highly anticipated new type of
exchange-traded fund.”); Chuck Jaffe, Next Generation of ETFs Will Reshape Fund
Business, THOMSON FIN. NEWS (Sept. 27, 2006) (Westlaw, Thomsonfin) (“Regulators who
have been winking at the new [ETFs] and allowing them to be ‘active’ but not ‘actively
managed’ are likely to cross that line in the near future. You can expect actively managed
ETFs by year’s end.”).
6. SEC Proposed Rules, supra note 3, at 14,620 n.27 (“[E]ach of the actively managed
ETFs operating under the recent exemptive orders approved by the Commission is required
to make public each day the securities and other assets in its portfolio.”).
7. Id. at 14,623; see Stacy L. Fuller, The Evolution of Actively Managed Exchange-
Traded Funds, REV. SEC. & COMMODITIES REG., Apr. 16, 2008, at 89 (“By the end of 2007,
several hundreds of ETFs had been organized—all of them, index-based.”).
8. SEC Proposed Rules, supra note 3, at 14,623.
9. Id. at 14,625 n.95.
10. See Press Release, Foley & Lardner LLP, Foley & Lardner LLP Counsels First
Actively-Managed Exchange Traded Fund (Mar. 12, 2008),
http://www.foley.com/news/news_detail.aspx?newsid=3408 (discussing how the first
actively managed ETF, The Bear Stearns Current Yield Fund (YYY), would report its entire
u nderlying portfolio online each day).
2008] ARBITRAGE AND EXCHANGE-TRADED FUNDS 97
new round of speculation regarding the next era in the evolution of ETF
products, the SEC noted, “[b]y proposing [a rule to permit fully transparent
ETFs to register without securing individual exemptive orders] we are not,
however, suggesting that we will not consider applications for exemptive
orders for actively managed ETFs that do not satisfy the proposed rule’s
transparency requirements.”11
Prior to recent approvals, the SEC had left actively managed ETFs
suspended in regulatory stasis pending the resolution of transparency
concerns.12 As reflected in a 2001 concept release, the SEC hesitated to
approve actively managed structures because fund managers might
sacrifice transparency—“a hallmark of ETFs”13—for stronger market
performance.14 Equity index ETFs had always published daily the
securities needed to acquire shares from funds, as well as the securities
tendered to investors when creation units were redeemed.15 Andrew
Donohue, Director of the SEC’s Division of Investment Management,
explained that the Commission feared fund managers would act to prevent
“too much transparency,”16 a move perceived as dangerous, particularly in
a shifting market environment where increasing numbers of retail investors
are trading ETF shares.17 In approving the first actively managed ETFs,
the SEC, rather than overcoming its concerns with transparency, simply
limited current approvals to transparent structures. As a result, while active
management represents a new evolution in the ETF industry, newly-
approved funds remain firmly anchored—at least for now—to the same
principles that underlie previous approvals of equity index ETFs.
This Article does not attempt to predict whether or when the SEC will
approve an actively managed ETF that does not conform to current
transparency requirements, but instead takes a backward glance at the
regulatory approval process, with the view that a look back may reveal
significant information about the future. As curious investment structures

11. SEC Proposed Rules, supra note 3, at 14,623.
12. See Andrew J. Donohue, Dir., Div. of Inv. Mgmt., Sec. & Exch. Comm’n, Speech
by SEC Staff: Remarks Before the 4th Annual Art of Indexing Summit (Sept. 20, 2006),
http://www.sec.gov/news/speech/2006/spch092006ajd.htm.
13. Id.
14. Id.
15. See, e.g., 1 Reg. of Inv. Companies (MB) § 26.02[1][a] (2008) (describing
transparency in ETF formation and operation).
16. Donohue, supra note 12.
17. See, e.g., Rebecca Knight, Irresistible Rise of the Flexible Fund, FIN. TIMES USA,
Jan. 10, 2006, at 10 (reporting that two-thirds of a major U.S. bank’s ETF trades have come
from retail investors); see also Lawrence C. Strauss, New Frontier: ETFs Are Surging in
Popularity. Get Ready for Actively Managed Versions. (Exchange-Traded Funds),
BARRON’S, Jan. 3, 2005, at F5 (noting ETFs are popular with both retail and institutional
investors).
98 U. OF PENNSYLVANIA JOURNAL OF BUSINESS LAW [Vol. 11:1
that traverse the line between open-end18 and closed-end19 funds, ETFs
already have raised numerous regulatory headaches underscored by
unspoken normative judgments, some of which can be extracted from a
web of exemption letters and statutory language. If there is an element
common to ETF approvals, it is that all are based on a delicate regulatory
surgery performed under the Investment Company Act of 1940.20
Rather than strike directly at the issue of active management, this
Article seeks to distill the underlying assumptions, goals, and regulatory
values that inform the history of exemptive relief under the Investment
Company Act for equity index ETFs and, now, actively managed,
transparent ETFs. The Article concludes that the common principles
behind various exemptions unite to support a general theory of how
regulators believe the ETF market should function. Transparency, at both
the index and the portfolio level, has been the cornerstone of exemptive
relief from various provisions of the Act, because it fosters an arbitrage
mechanism that protects retail investors by creating price effects that ripple
through the secondary market and push trading prices toward net asset
value (NAV).21 Embedded within regulatory deference to the ETF
arbitrage system is the SEC’s implicit recognition that the natural
corrective abilities of a liquid and transparent market often protect
investors more effectively than regulatory mandates. This Article takes the
position that an arbitrage-driven price stability regime is the central reason
why index-tracking and transparent actively managed ETFs have received
exemptive relief from various constraints imposed by the Investment
Company Act.22

18. The Investment Company Act defines an open-end company as “a management
company which is offering for sale or has outstanding any redeemable security of which it is
the issuer.” 15 U.S.C. § 80a-5(a)(1) (2000).
19. See, e.g., 15 U.S.C. § 80a-5(a)(2) (2000) (defining a closed-end investment
company under the Investment Company Act as simply “any management company other
than an open-end company”); see also SEC, Closed-End Funds, Answers Page,
http://www.sec.gov/answers/mfclose.htm (last visited Oct. 16, 2008) (explaining that
closed-end funds typically offer a fixed number of shares in an initial public offering and
later trade on secondary exchanges). Shares in closed-end funds usually are not redeemable,
such that closed-end funds are not subject to the same liquidity requirements as open-end
funds. Id.
20. As Stacy L. Fuller explains, exemptive relief from the Investment Company Act
requires that regulators deviate from the letter of the statute: “While the 1940 Act provides
clear and divergent regulatory regimes for open- and closed-end funds, it does not provide a
regime for open- and closed-end hybrids, such as ETFs. The SEC plays an important role in
filling that vacuum, by using its exemptive powers to create a regulatory regime for ETFs.”
Fuller, supra note 7, at 91.
21. See infra Part II.D (discussing transparency and the arbitrage system).
22. The proposition that arbitrage has informed exemptive relief for ETFs is not a
controversial one. In its Proposed Rules, the SEC requested comment on the following
q uestion: “Does the requirement that an ETF establish creation unit sizes the number of
2008] ARBITRAGE AND EXCHANGE-TRADED FUNDS 99
If an efficient arbitrage mechanism is critical to investor protection,
and if arbitrageurs require transparency to perform their stabilizing
function, then what is to be said of non-transparent actively managed
ETFs? Some commentators focus on the risk of front-running,23 and how it
may raise concerns about openness by fund managers.24 Depending on the
financial innovations underway to counteract this situation, actively
managed ETFs may indeed provide investors with less transparency than
the index-tracking variety.25 Nonetheless, this Article does not predict
whether the SEC will eventually approve non-transparent actively managed
ETFs, but instead aims to shed light on why the SEC has approved the
existing class of transparent funds. By subjecting the evolution of SEC
approval of transparent ETFs to the harsh gaze of hindsight, this Article
intends to help clear a path for future structures by navigating the often-
tangled maze of values that has produced the first two generations of ETF
products.
II. FINANCIAL STRUCTURE
A. The Indexing Tradition
Despite the SEC’s recent approval of actively managed ETFs, most
existing ETFs remain passive26 instruments that track an underlying
securities index,27 such that the portfolio changes only in response to a

which is reasonably designed to facilitate arbitrage provide the sponsor or advisor of the
ETF with sufficient guidance in setting appropriate thresholds?” SEC Proposed Rules,
supra note 3, at 14,627. This Article seeks to advance the discussion of the role arbitrage
plays in the regulation of ETFs, by exploring the nuances and specific justifications behind
its importance in the regulatory setting.
23. See Thao Hua, Bear Stearns Could Land 1st Active ETF on U.S. Shores, PENSIONS
& INVESTMENTS, Apr. 30, 2007 (noting that transparency is one of the biggest challenges
facing actively managed ETFs, because managers must fully disclose the underlying
portfolio and run the risk that other managers may front-run their strategies); Raquel
Pichardo, Solving Puzzle of Active ETFs, PENSIONS & INVESTMENTS, Oct. 1, 2007
(explaining that transparency is the most daunting regulatory hurdle facing fund managers
who are trying to launch the next wave of ETFs, because “[m]anagers worry that full
transparency of their trades will betray their investment processes and open the door to
front-runners”).
24. Pichardo, supra note 23.
25. See sources cited in supra note 23 (discussing risks of transparency to fund
managers).
26. Here, “passive” indicates a lack of active trading by fund managers.
27. See e.g., SEC, Exchange-Traded Funds (ETFs), http://www.sec.gov/answers/etf.htm
(last visited Oct. 23, 2008) (noting, in 2007, that “all ETFs seek to achieve the same return
as a particular market indexes [sic]”).
100 U. OF PENNSYLVANIA JOURNAL OF BUSINESS LAW [Vol. 11:1
change in the index.28 Equity index ETFs “closely mirror” their underlying
indices, making portfolio turnover rare.29 Traditional securities indices30
typically include equities based on capitalization weighting,31 which is
partially explained by the relationship between high capitalization and
liquidity.32 Early ETFs strove to replicate the performance of traditional
stock indices such as the Dow Jones Industrial Average and the S&P 500
Index.33
Before actively managed structures emerged, the ETF industry began
to develop new indices for the purpose of launching equity index ETFs.34
Fueled by the growing popularity of ETFs as investment vehicles, sector-
specific and fund-specific indices have produced increasingly narrow
benchmarks.35 The demand for increasingly diverse offerings has created a
situation where “more indices are being developed to form the basis of new
ETFs,”36 marking a change from the time when ETFs were built around
then-existing, traditional indices.37 While “fund-friendly” indices may use
the same capitalization method of traditional benchmark indices, they differ

28. See Anthony Ragozino & Charlie J. Gambino, Actively-Managed Exchange Traded
Funds: Coming Soon to a Market Near You? 8 INVESTMENT LAWYER 3 (2001) (explaining
that an ETF is designed to track a particular stock index, such that the ETF’s portfolio
changes only if the benchmark index changes).
29. Vipul K. Bansal & Archana Somani, Exchange Traded Funds: Challenge to
Traditional Mutual Funds, REV. OF BUS., Fall 2002, at 41.
30. Indices such as the Dow Jones Industrial Average, the S&P 500 Index, and the
NASDAQ Composite Index were not “originally created with the idea that a fund portfolio
replicating the structures and rules of the index would be a popular investment. These
indexes were developed to serve as market indicators and/or as a standard for comparison
with actual portfolios managed by active portfolio managers.” GARY L. GASTINEAU, THE
EXCHANGE-TRADED FUNDS MANUAL 131 (John Wiley & Sons, Inc. 2002).
31. See, e.g., id. at 131 (noting that, with the exception of the original Dow Jones
Industrial Average and the Nikkei Average, most popular indices are capitalization
weighted).
32. See id. at 132 (correlating market capitalization and liquidity).
33. See, e.g., Diya Gullapalli, Why Hot Funds are Tripping Up Some Investors–ETFs,
Which are Meant to Track Benchmarks, Increasingly Go Astray, WALL ST. J., Apr. 19,
2007, at A1 (explaining that ETFs “were designed to match the performances of various
market benchmarks, such as the Standard & Poor’s 500-stock index”).
34. See GASTINAEU, supra note 30, at 132-33 (discussing reasons for the development
of new indices that depart from the capitalization weighted approach); see also SEC
Proposed Rules, supra note 3, at 14,619 (explaining that many newer ETFs are based on
more specialized indices, including some designed specifically for a particular ETF).
35. Exchange Traded Funds Growing in Popularity, INVESTMENT ADVISER, June 4,
2007, http://www.ftadviser.com (search “Exchange Traded Funds Growing in Popularity”;
then follow article hyperlink).
36. Id.
37. See, e.g., Authers & Knight, supra note 5, at 11 (observing that while ETFs
traditionally were based on conventional indices and weighted by market capitalization,
ETF providers recently have launched funds that incorporate alternative weighting
strategies).
2008] ARBITRAGE AND EXCHANGE-TRADED FUNDS 101
by considering “the structural requirements of funds, the economics of
trading, the investment objectives of funds, and the presence of other
investors in the marketplace.”38 Others use alternative weighting
methodologies39 that depart from capitalization weighting to incorporate
factors such as cash flow, dividends, sales, and book value.40 Sampling
strategies, in which ETFs track a limited array of securities from a given
index based on a wide array of selection strategies, are also common.41 For
example, the benchmark index might be limited to securities that come out
favorably in a dividend weighting evaluation.42 These new indices
“convert an established stock selection process into an index which serves
as the template for a portfolio.”43 Unsurprisingly, given the demand for
increasingly specialized sector exposure, recently-developed indices have
led to ETFs “of virtually every flavor,”44 including those that track private
equity, gold, vaccines, intellectual property, nanotechnology, and
renewable energy.45 Demand for greater sector exposure has also led to
commodities ETFs that, unlike mutual funds that hold equity in publicly-
traded commodities companies, attempt to track the prices of the
underlying commodities themselves, typically through direct ownership or
futures contracts.46

38. GASTINAEU, supra note 30, at 132.
39. Authers & Knight, supra note 5, at 11.
40. ETFs Growing in Popularity, supra note 35; see also Rob Carrick, The Case for
Blending Passive, Active Indexing, GLOBE & MAIL UPDATE, May 19, 2007 (describing the
new paradigm of fundamental indexing as a refinement of traditional indexing).
41. See Paul F. Roye, Dir., Div. of Inv. Mgmt., SEC, Speech by SEC Staff: Regulatory
Issues Involving Exchange Traded Funds at the American Stock Exchange Symposium on
Exchange Traded Funds, (Jan. 14, 2002), http://www.sec.gov/news/speech/spch534.htm
(explaining that “rather than holding securities that replicate an entire index, [an ETF] could
instead use ‘sampling techniques’ to track the performance of an index . . . . By ‘sampling’
the stocks in an index, the exchange traded fund can seek to replicate the performance of the
index without actually owning all the component stocks in the index.”).
42. See, e.g., Rob Garver, The ETF Evolution, BANK INV. CONSULTANT, Mar. 2007, at
25 (citing ETFs issued by WisdomTree Investments as an example).
43. GASTINAEU, supra note 30, at 165.
44. Chuck Jaffe, ETFs v. Mutual Funds: Winner Depends on You, THOMSON FIN.
NEWS, July 30, 2006.
45. Revolution or Pollution? Exchange-Traded Funds, ECONOMIST, Apr. 21, 2007, at
83-84; see David E. Stout & Huaiyu Chen, A Primer on Exchange Traded Funds: Purpose,
Operation, and Risk, THE CPA J., Sept. 2006, at 56 (commenting that the list of ETFs is
comprehensive enough that today’s investors “can use ETFs to cover all the sectors, styles,
and market capitalization options associated with ordinary mutual fund investments”).
46. See, e.g., Philip McBride Johnson, The CFTC and Commodity-Based Exchange-
Traded Funds, 11 DERIVATIVES USE, TRADING & REG. 303, 304 (2006) (noting that ETFs
commonly are tied in value to the price of gold or other commodities trading on a futures
exchange); see also Robert S. Bernstein, Oil, Currency, and Silver Commodities Come to
the Securities Market, 33(4) CORP. TAXATION 40 (2006) (noting the emergence of
commodity-based ETFs).
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B. Actively Managed, Transparent ETFs
The new structures that the SEC approved in early 2008 differ from
their predecessors in that fund managers are no longer bound by the
confines of a particular securities index. Nevertheless, all actively
managed ETFs approved by the SEC must disclose their portfolio holdings
daily, just like the traditional index-tracking variety that preceded them.47
The commonality between the first actively managed ETFs and traditional
equity index ETFs is that both are “fully transparent.”48 The first
generation of actively managed ETFs provides disclosure in largely the
same manner as index-tracking funds49 with the main difference
concerning an enhanced freedom to select and trade portfolio securities.
While ETF fund managers are no longer confined to a particular index, the
SEC nonetheless limits its approval “to transparent actively managed
ETFs,”50 which must fully disclose their holdings.51 All existing ETFs may
therefore be characterized as transparent.
C. Creation and Redemption
In most cases, an authorized participant52 creates an ETF by
depositing a block of securities, called a portfolio deposit,53 with a
custodian in exchange for shares of equivalent value.54 The authorized
participant receives from the ETF sponsor a block of shares called a

47. See WisdomTree Trust, Notice of Application, supra note 1, at 7780 (“On each
Business Day, before the commencement of trading in Shares on the Fund’s listing
Exchange, the Fund will disclose on its Web site the identities and quantities of the money
market securities and other assets held by the Fund that will form the basis for the Fund’s
calculation of NAV at the end of the Business Day.”).
48. SEC Proposed Rules, supra note 3, at 14,623.
49. Id.
50. Id. at 14,642.
51. As the SEC explains, “[a]n ETF that chooses not to disclose its portfolio would
have to track an index whose provider discloses the identities and weightings of the
securities and other assets that constitute the index in order to rely on the proposed rule.”
Id. at 14,642-43.
52. Authorized participants are institutional investors that create ETFs by acquiring the
necessary portfolio securities. See, e.g., CHRISTINE BRENTANI, PORTFOLIO MANAGEMENT IN
PRACTICE 167 (Elsevier Ltd. 2001) (2004) (explaining that, when demand for an ETF is
expected, a large intermediary broker/dealer or authorized participant buys securities
representing an underlying index).
53. Portfolio deposits “essentially need to match the index underlying the fund and be
acceptable to the fund’s adviser.” Reg. of Inv. Companies, supra note 15, § 26.02[1][a].
54. See Bansal & Somani, supra note 29, at 40 (discussing ETF formation); Phyllis J.
Bernstein, A Primer on Exchange-Traded Funds, J. ACCT., Jan. 1, 2002, at 39-40
( discussing the ETF share-creation process).
2008] ARBITRAGE AND EXCHANGE-TRADED FUNDS 103
creation unit, which typically contains 50,000 or more shares of the ETF.55
Because the value of a creation unit will equal that of its corresponding
ETF shares,56 portfolio deposits may include a small amount of cash to
balance differences between the value of the deposit and the shares’
NAV.57 Investors also may acquire creation units on the secondary market
by purchasing a sufficient number of shares.58 As a result, ETFs operate in
two markets; creations and redemptions define the primary market, while
investors who trade shares on an exchange create the secondary market.59
ETF shares are redeemed through “in kind” transfers, which exchange
creation units for their underlying portfolio securities.60 ETF shares are not
redeemable individually,61 a feature that distinguishes them from most
open-end funds.62 Redemptions are priced by the end-of-day NAV and
thus protect shares from dilution.63 In-kind redemption also shelters ETF
shareholders from the tax consequences of cash-redeemable mutual
funds,64 as in-kind redemption uses a direct securities transfer rather than a

55. Stuart M. Strauss, Exchange Traded Funds—the Wave of the Future? 7
INVESTMENT LAWYER 1, 15 (2000).
56. Actively Managed Exchange-Traded Funds, Investment Act Release No. IC-25258,
66 Fed. Reg. 57,614, 57,616 (Nov. 8, 2001).
57. Id.
58. See, e.g., Bernstein, supra note 54, at 39 (noting that broker-dealers often break up
creation units and offer ETF shares on the exchanges where individual investors can buy
them).
59. See Ragozino & Gambino, supra note 28, at 3 (explaining that there are really “two
markets” for ETFs); see also DOUGLAS S. ROGERS, TAX AWARE INVESTMENT MANAGEMENT
106 (Bloomberg Press 2006) (listing the two types of markets for ETFs as a primary market
of authorized participants and a secondary market of individual investors); Ira P. Shapiro,
An Introduction to U.S. ETFs, in PRACTISING LAW INST., NUTS & BOLTS OF FIN. PRODUCTS
2008 357, 361 (2008) (stating that most investors buy and sell ETF shares on the exchange,
instead of making direct purchases and redemptions from the fund itself as they would do
with index mutual funds); Letter from Philippe El-Asmar, Managing Dir., Barclays Capital
Inc., to Nancy M. Morris, Sec’y, Sec. & Exch. Comm’n 2 (May 8, 2008) (on file with
author), http://www.sec.gov/comments/s7-07-08/s70708-4.pdf (noting transactions with
ETFs are limited to Authorized Participants, whereas “retail investors purchase and sell ETF
shares in secondary market transactions”).
60. BRENTANI, supra note 52, at 167.
61. See, e.g., Actively Managed ETFs, supra note 56, at 57,621 (“Because ETF shares
are not individually redeemable, an ETF requests relief to permit the ETF to register and
operate as an open-end fund and to issue shares that are redeemable in Creation Units
only.”).
62. See Investment Company Act, 15 U.S.C. § 80a-5(a)(1) (2000) (indicating that open-
end funds traditionally redeem all shares).
63. American Stock Exchange LLC, Explanation of ETFs,
http://www.amex.com/?href=/etf/eductn/etf_edu_instit.html (last visited Oct. 16, 2008).
64. The following is a summary of the two primary tax advantages of ETFs over mutual
funds:
First, because retail investors go directly to the market to obtain cash for their
shares, the fund manager does not have to sell shares that would trigger capital-
104 U. OF PENNSYLVANIA JOURNAL OF BUSINESS LAW [Vol. 11:1
sale yielding taxable gains.65 Capital gains taxes are deferred until
investors sell the securities,66 which in turn controls costs for the remaining
shareholders67 and supports the claim that in-kind creation and redemption
provide for “relatively frictionless portfolio turnover.”68

D. The Arbitrage Mechanism
ETF shares trading on secondary exchanges can experience deviations
between share price and the NAV of their underlying portfolio securities.69
While ETF share prices track the NAV of the fund’s portfolio securities,70
short-term differences between the two prices nonetheless occur.71 The
trading environment causes this deviation, marking a critical difference
between an ETF and an open-end mutual fund. The share price of an open-
end mutual fund “always equals its NAV,”72 which, coupled with the

gain distributions for the remaining shareholders. Second, creation unit holders
can redeem their shares for the underlying stock rather than cash, thus deferring
the gain or loss until the distributed shares are sold by the investor.
See, e.g., Randy Gardner & Julie A. Welch, Increasing After-Tax Returns with Exchange
Traded Funds, J. FIN. PLANNING, June 2005, at 31, available at
http://www.fpanet.org/journal/articles/2005_Issues/jfp0605-art4.cfm.
65. See Kathleen Moriarty, Exchange-Traded Funds: Legal and Structural Issues
Worldwide, 29 INT’L BUS. L. 346, 349 (2001) (“[T]he ETF satisfies redemptions by
providing the redeeming party with the actual basket of designated stocks, rather than cash
proceeds resulting from the sale of such stocks . . . .”); see also Svea Herbst-Bayliss,
Fidelity Opens Magellan Fund to New Investors, REUTERS, Jan. 14, 2008,
http://www.reuters.com/article/companyNews/idUSN1441753420080114 (reporting that
Fidelity re-opened its Magellan mutual fund to new investors following increasing
withdrawals by retirees, which frequently forced the fund manager “to sell stocks he liked in
order to have enough cash on hand to meet redemptions”).
66. See Gardner & Welch, supra note 64, at 31 (citing this as a tax advantage); see also
Stout & Chen, supra note 45, at 57 (explaining in regard to the in-kind redemption process:
“According to the IRS, this exchange of essentially identical items does not trigger capital
gains. Thus, ETF shares allow an investor to delay payment of capital gains tax until the
final sale of the ETF shares.”).
67. See Gardner & Welch, supra note 64 (contrasting the relatively high capital gains
taxes associated with regular mutual funds with those associated with ETFs).
68. Moriarty, supra note 65, at 348.
69. Plante Moran Fin. Advisors, Exchange-Traded Funds Revisited 1 (2006),
http://www.plantemoran.com (search “Exchange-Traded Funds Revisited”; then follow “full
article” hyperlink).
70. Stuart Strauss & Scott M. Zoltowski, Exchange Traded Funds, in A.L.I.-A.B.A.,
INVESTMENT MGMT. REG. 67, 70 (Aug. 2006).
71. See John Demaine, Exchange Traded Funds for the Sophisticated Investor, 7
DERIVATIVES USE, TRADING & REG. 354, 355 (2002) (“While both ETFs and futures tend to
track underlying cash indices tightly over a period of time, in the short term they can trade
significantly away from ‘fair value.’”).
72. Plante Moran Fin. Advisors, supra note 69, at 1.